The capital dividend account_en_LL.docx
The capital dividend account Integration The taxation of private corporations in Canada is based on the principle of “integration.” Integration exists if the combined amount of tax on income earned by a private corporation, and the tax on dividend paid to the individual shareholder(s), is approximately the same amount that would have been paid if the corporation’s income had been earned directly by the shareholder(s).
The capital dividend account (CDA) One mechanism used to ensure integration of taxes payable by a private corporation and its shareholder(s) is the capital dividend account. This is a notional account and its purpose is to keep track of certain amounts received by a private corporation that, had they been received directly by the shareholder, would have also been tax-free. There are four main components or tax-free amounts that determine the capital dividend account balance: • •
•
the non-taxable portion of capital gains exceeding the non-deductible portion of capital losses the non-taxable portion from the sale of eligible capital property1 (for example, goodwill) that exceeds amounts deducted under subsection 20(4.2)2 or allowable capital losses under subsection 20(4.3)3 capital dividends received from another private corporation
•
life insurance proceeds (in excess of the corporation’s adjusted cost basis in the policy) received by the corporation as beneficiary
These non-taxable receipts are credited to the capital dividend account, which can be paid out to the Canadian resident shareholder(s) as tax-free4 capital dividends. Private corporations (but not public corporations) resident in Canada may have this type of account. The other component in determining the capital dividend account balance is deducting previously paid capital dividends. This computation of the capital dividend account is shown in the diagram on the next page. As mentioned, one of the items creating a credit to the capital dividend account is the receipt of a life insurance policy death benefit by a corporate beneficiary. Generally, life insurance proceeds are received by the corporation tax-free and may then be used for any purpose. For example, if a life insurance policy is collaterally assigned to a bank, the death benefit proceeds would first be used to repay the bank loan. While the repayment would leave less cash in the company, the entire death benefit less adjusted cost basis is still credited to the corporation’s capital dividend account.
Facts about the capital dividend account 1. The capital dividend account balance can be calculated at any point in time and not necessarily at the company’s year-end (for example, the balance can be calculated and paid out following
This material is for information purposes only and should not be construed as providing legal or tax advice. Reasonable efforts have been made to ensure its accuracy, but errors and omissions are possible. All comments related to taxation are general in nature and are based on current Canadian tax legislation and interpretations for Canadian residents, which is subject to change. For individual circumstances, consult with your legal or tax professional. This information is provided by London Life Insurance Company and is current as of December, 2012. © London Life Insurance Company, all rights reserved. London Life and design are trademarks of London Life Insurance Company.
the realization of a capital gain or the receipt of a life insurance death benefit). 2. The calculation begins from the time the corporation became a private company (on incorporation as a private company or ceasing to be a public company). A full historical calculation of the capital dividend account is required before paying a capital dividend.
person, and the greater the amount that may be paid as a tax-free capital dividend to the Canadian resident shareholders.
Examples of calculations Question 1: It’s Oct. 1, 2012 and private Corporation X asks, what’s our capital dividend account balance?
Facts: The corporation’s taxation year-end is Dec. 3. A negative amount in one component of the capital dividend account does not affect the other components that go into the calculation of the balance (for example, a capital loss realized from the sale of property does not detract/is not subtracted from the calculation that includes the receipt of a life insurance death benefit).
31. There have been no other transactions in the corporation’s history that affected the capital dividend account before Sept. 30, 2012. On Sept. 30, 2012, Corporation X realized a capital loss of $100,000 (non-deductible capital loss of $50,000) and received a capital dividend from a subsidiary corporation of $50,000.
4. The credit to the capital dividend account for a life insurance death benefit is the amount by which the life insurance death benefit exceeds the adjusted cost basis of the life insurance policy.
Answer: $50,000
5. The adjusted cost basis of a life insurance policy (issued after Dec. 1, 1982) is generally equal to the premiums paid for the policy, less the net cost of pure insurance. The net cost of pure insurance is the pure mortality expense for the death benefit under the policy as prescribed by regulations under Canada’s Income Tax Act (ITA). This cost increases as the insured person gets older. In the later years of a policy, the adjusted cost basis begins declining as a result of the net cost of pure insurance deduction. This factor may have favourable implications for a corporation that owns and is the beneficiary of a life insurance policy. The lower the adjusted cost basis of the policy, the greater the credit to the capital dividend account is on the death of the insured
Explanation: Capital dividend account components/tax-free amounts are separately calculated and don’t affect other components in the computation. A component in the capital dividend account calculation cannot be negative. The capital gain/loss component is therefore $0, and the capital dividends received component is $50,000.
Question 2: It’s Nov. 1, 2012 and Corporation X asks, what’s our capital dividend account balance?
More facts: Corporation X paid a $50,000 capital dividend to its shareholders on Oct. 15, 2012. On Oct. 31, Corporation X realized a capital gain of $80,000 (non-taxable capital gain of $40,000) and received a $500,000 death benefit from a life insurance policy on a key executive. The policy had an adjusted cost basis of $100,000.
Answer: $400,000
Explanation: A historical capital dividend account calculation shows capital gain/loss component is $0 since it cannot be negative ($50,000 non-deductible capital loss minus $40,000 non-taxable capital gain). Life insurance death benefit component is $400,000 ($500,000 death benefit less $100,000 adjusted cost basis). The capital-dividends-received component is $50,000 and the capital-dividends-paid component is $50,000.
capital dividend account. Soon after, the corporation declared a capital dividend of $500,000. In 2012, the corporation realizes a capital loss of $1 million (nondeductible capital loss of $500,000), and receives a death benefit of $1,500,000. The adjusted cost basis of the policy was $nil.
Question: Can the corporation declare a capital dividend in 2012 after receiving the death benefit?
Question 3: It’s Dec. 1, 2012 and Corporation X
Answer: Yes, but in this instance, only part of the
asks, what’s our capital dividend account balance?
death benefit received can be distributed as tax-free capital dividend.
More facts: On Nov. 15, Corporation X paid a $400,000 capital dividend to its shareholders. On Nov. 30, Corporation X realized a capital gain of $50,000 (non-taxable capital gain of $25,000).
Answer: $15,000 Explanation: A historical capital dividend account calculation shows capital gain/loss component is $15,000 ($40,000 non-taxable capital gain plus $25,000 non-taxable capital gain minus $50,000 nondeductible capital loss). The capital dividends received component is $50,000, the life insurance death benefit component (less adjusted cost basis) is $400,000 and the capital dividends paid component is $450,000 ($50,000 paid Oct. 15 and $400,000 paid Nov. 15).
Another example As the computation of the balance in the capital dividend account is done on a cumulative basis, transactions and capital dividends paid in prior years impact the calculation in the current year.
Facts: In 2011 a private corporation realized a capital gain of $1 million. Fifty per cent of this gain (non-taxable portion), $500,000, was added to the
Explanation: A historical capital dividend account calculation would be as under: 2011 non-taxable portion of capital gain
$500,000
2012 non-deductible portion of capital loss $500,000 Net non-taxable gain
(A)
$Nil
Death benefit less adjusted cost basis(B) $1,500,000 Subtotal
(A) + (B) $1,500,000
Less: capital dividends paid
$500,000
Capital dividend account balance
$1,000,000 ======== In this case, only a capital dividend of $1,000,000 may be paid (rather than a full $1,500,000 capital dividend as a result of the tax-free death benefit) because of previous transactions that affect the capital dividend account balance.
Value of corporate-owned life insurance A corporation may purchase life insurance for any number of reasons, including: •
Funding buy-sell terms in a shareholders agreement
• • •
•
• •
•
Succession planning, redemption of freeze shares Funding tax liabilities (corporate/shareholder estate tax) Business protection for o debt repayment (line of credit or bank loan) o other creditors / suppliers o loss of key employee/executive Executive compensation; shared interest strategies, retirement compensation arrangements Insured annuities Corporate philanthropy Tax-advantaged wealth accumulation, estate enhancement and leveraging strategies
As noted earlier, a credit to the capital dividend account can allow for either an immediate or future tax-free distribution of capital dividends to Canadian resident shareholder(s). This benefit should not be ignored when considering the purchase of corporateowned life insurance.
Paying capital dividends The payment of a capital dividend is optional and a private corporation can pay an ordinary taxable dividend even if, at the time, there is a credit balance in its capital dividend account. The procedure for payment of capital dividend is straightforward and includes the following steps: 1. The corporation, usually through its tax accountant, completes Canada Revenue Agency (CRA) form T20545 in which the corporation elects, under subsection 83(2)6, that the dividend it proposes to pay out will be treated as a capital dividend. 2. An original of this election form, along with a certified copy of the director’s resolution
authorizing the election, must be sent to CRA on or before the earlier of the date on which the dividend becomes payable or the date it was paid. 3. A schedule showing the capital dividend account calculation immediately before the capital dividend is paid must be sent to CRA. A penalty is payable for late filing of this election form. Calculation of the capital dividend must always be left to the corporation’s accountant for two reasons. First, it can be an involved and complex calculation and second, an error in paying an amount in excess of the capital dividend account balance results in the excess being considered a separate taxable dividend to the shareholder(s), if all shareholder(s) agree; or a tax penalty to the corporation. The timing of the payment of a capital dividend is at the discretion of the corporation. It does not have to wait until the end of a fiscal year, nor does it have to pay amounts out as soon as they’re credited to the capital dividend account. However, where the capital dividend account is used in conjunction with a buy-sell agreement, great care should be taken with respect to the timing of the payment. While there’s no requirement a corporation file any other forms with CRA when paying a capital dividend, it’s good practice for the corporation to tell shareholders receiving such dividends that they are capital dividends, and therefore tax-free, if they are Canadian residents.
Conclusion The capital dividend account of a private corporation is important in ensuring tax-free amounts received by the corporation are tracked. Understanding how the capital dividend account is calculated is important. It plays a critical role for the distribution of tax-free
amounts to Canadian resident shareholder(s), including the death benefit received by the private corporation as beneficiary of a life insurance policy. 1
Gains on eligible capital property dispositions are only credited to the capital dividend account at the end of a taxation year. There is a risk of over-electing if this gain is added to and included in a tax free capital dividend that is paid before a corporation’s year-end. 2
Refers to Income Tax Act Canada, for Quebec provincial tax purposes refer section 142.1 of Quebec Taxation Act. 3
Refers to Income Tax Act Canada, for Quebec provincial tax purposes refer section 142.2 of Quebec Taxation Act. 4
Tax withholding is required if the shareholder is non-resident of Canada.
5
For Quebec provincial tax purposes also file form CO-502 with Revenu Quebec. 6
Refers to Income Tax Act Canada, for Quebec provincial tax purposes refer section 502 of Quebec Taxation Act.
The capital dividend account (CDA) One mechanism used to ensure integration of taxes payable by a private corporation and its shareholder(s) is the capital dividend account. This is a notional account and its purpose is to keep track of certain amounts received by a private corporation that, had they been received directly by the shareholder, would have also been tax-free. There are four main components or tax-free amounts that determine the capital dividend account balance: • •
•
the non-taxable portion of capital gains exceeding the non-deductible portion of capital losses the non-taxable portion from the sale of eligible capital property1 (for example, goodwill) that exceeds amounts deducted under subsection 20(4.2)2 or allowable capital losses under subsection 20(4.3)3 capital dividends received from another private corporation
•
life insurance proceeds (in excess of the corporation’s adjusted cost basis in the policy) received by the corporation as beneficiary
These non-taxable receipts are credited to the capital dividend account, which can be paid out to the Canadian resident shareholder(s) as tax-free4 capital dividends. Private corporations (but not public corporations) resident in Canada may have this type of account. The other component in determining the capital dividend account balance is deducting previously paid capital dividends. This computation of the capital dividend account is shown in the diagram on the next page. As mentioned, one of the items creating a credit to the capital dividend account is the receipt of a life insurance policy death benefit by a corporate beneficiary. Generally, life insurance proceeds are received by the corporation tax-free and may then be used for any purpose. For example, if a life insurance policy is collaterally assigned to a bank, the death benefit proceeds would first be used to repay the bank loan. While the repayment would leave less cash in the company, the entire death benefit less adjusted cost basis is still credited to the corporation’s capital dividend account.
Facts about the capital dividend account 1. The capital dividend account balance can be calculated at any point in time and not necessarily at the company’s year-end (for example, the balance can be calculated and paid out following
This material is for information purposes only and should not be construed as providing legal or tax advice. Reasonable efforts have been made to ensure its accuracy, but errors and omissions are possible. All comments related to taxation are general in nature and are based on current Canadian tax legislation and interpretations for Canadian residents, which is subject to change. For individual circumstances, consult with your legal or tax professional. This information is provided by London Life Insurance Company and is current as of December, 2012. © London Life Insurance Company, all rights reserved. London Life and design are trademarks of London Life Insurance Company.
the realization of a capital gain or the receipt of a life insurance death benefit). 2. The calculation begins from the time the corporation became a private company (on incorporation as a private company or ceasing to be a public company). A full historical calculation of the capital dividend account is required before paying a capital dividend.
person, and the greater the amount that may be paid as a tax-free capital dividend to the Canadian resident shareholders.
Examples of calculations Question 1: It’s Oct. 1, 2012 and private Corporation X asks, what’s our capital dividend account balance?
Facts: The corporation’s taxation year-end is Dec. 3. A negative amount in one component of the capital dividend account does not affect the other components that go into the calculation of the balance (for example, a capital loss realized from the sale of property does not detract/is not subtracted from the calculation that includes the receipt of a life insurance death benefit).
31. There have been no other transactions in the corporation’s history that affected the capital dividend account before Sept. 30, 2012. On Sept. 30, 2012, Corporation X realized a capital loss of $100,000 (non-deductible capital loss of $50,000) and received a capital dividend from a subsidiary corporation of $50,000.
4. The credit to the capital dividend account for a life insurance death benefit is the amount by which the life insurance death benefit exceeds the adjusted cost basis of the life insurance policy.
Answer: $50,000
5. The adjusted cost basis of a life insurance policy (issued after Dec. 1, 1982) is generally equal to the premiums paid for the policy, less the net cost of pure insurance. The net cost of pure insurance is the pure mortality expense for the death benefit under the policy as prescribed by regulations under Canada’s Income Tax Act (ITA). This cost increases as the insured person gets older. In the later years of a policy, the adjusted cost basis begins declining as a result of the net cost of pure insurance deduction. This factor may have favourable implications for a corporation that owns and is the beneficiary of a life insurance policy. The lower the adjusted cost basis of the policy, the greater the credit to the capital dividend account is on the death of the insured
Explanation: Capital dividend account components/tax-free amounts are separately calculated and don’t affect other components in the computation. A component in the capital dividend account calculation cannot be negative. The capital gain/loss component is therefore $0, and the capital dividends received component is $50,000.
Question 2: It’s Nov. 1, 2012 and Corporation X asks, what’s our capital dividend account balance?
More facts: Corporation X paid a $50,000 capital dividend to its shareholders on Oct. 15, 2012. On Oct. 31, Corporation X realized a capital gain of $80,000 (non-taxable capital gain of $40,000) and received a $500,000 death benefit from a life insurance policy on a key executive. The policy had an adjusted cost basis of $100,000.
Answer: $400,000
Explanation: A historical capital dividend account calculation shows capital gain/loss component is $0 since it cannot be negative ($50,000 non-deductible capital loss minus $40,000 non-taxable capital gain). Life insurance death benefit component is $400,000 ($500,000 death benefit less $100,000 adjusted cost basis). The capital-dividends-received component is $50,000 and the capital-dividends-paid component is $50,000.
capital dividend account. Soon after, the corporation declared a capital dividend of $500,000. In 2012, the corporation realizes a capital loss of $1 million (nondeductible capital loss of $500,000), and receives a death benefit of $1,500,000. The adjusted cost basis of the policy was $nil.
Question: Can the corporation declare a capital dividend in 2012 after receiving the death benefit?
Question 3: It’s Dec. 1, 2012 and Corporation X
Answer: Yes, but in this instance, only part of the
asks, what’s our capital dividend account balance?
death benefit received can be distributed as tax-free capital dividend.
More facts: On Nov. 15, Corporation X paid a $400,000 capital dividend to its shareholders. On Nov. 30, Corporation X realized a capital gain of $50,000 (non-taxable capital gain of $25,000).
Answer: $15,000 Explanation: A historical capital dividend account calculation shows capital gain/loss component is $15,000 ($40,000 non-taxable capital gain plus $25,000 non-taxable capital gain minus $50,000 nondeductible capital loss). The capital dividends received component is $50,000, the life insurance death benefit component (less adjusted cost basis) is $400,000 and the capital dividends paid component is $450,000 ($50,000 paid Oct. 15 and $400,000 paid Nov. 15).
Another example As the computation of the balance in the capital dividend account is done on a cumulative basis, transactions and capital dividends paid in prior years impact the calculation in the current year.
Facts: In 2011 a private corporation realized a capital gain of $1 million. Fifty per cent of this gain (non-taxable portion), $500,000, was added to the
Explanation: A historical capital dividend account calculation would be as under: 2011 non-taxable portion of capital gain
$500,000
2012 non-deductible portion of capital loss $500,000 Net non-taxable gain
(A)
$Nil
Death benefit less adjusted cost basis(B) $1,500,000 Subtotal
(A) + (B) $1,500,000
Less: capital dividends paid
$500,000
Capital dividend account balance
$1,000,000 ======== In this case, only a capital dividend of $1,000,000 may be paid (rather than a full $1,500,000 capital dividend as a result of the tax-free death benefit) because of previous transactions that affect the capital dividend account balance.
Value of corporate-owned life insurance A corporation may purchase life insurance for any number of reasons, including: •
Funding buy-sell terms in a shareholders agreement
• • •
•
• •
•
Succession planning, redemption of freeze shares Funding tax liabilities (corporate/shareholder estate tax) Business protection for o debt repayment (line of credit or bank loan) o other creditors / suppliers o loss of key employee/executive Executive compensation; shared interest strategies, retirement compensation arrangements Insured annuities Corporate philanthropy Tax-advantaged wealth accumulation, estate enhancement and leveraging strategies
As noted earlier, a credit to the capital dividend account can allow for either an immediate or future tax-free distribution of capital dividends to Canadian resident shareholder(s). This benefit should not be ignored when considering the purchase of corporateowned life insurance.
Paying capital dividends The payment of a capital dividend is optional and a private corporation can pay an ordinary taxable dividend even if, at the time, there is a credit balance in its capital dividend account. The procedure for payment of capital dividend is straightforward and includes the following steps: 1. The corporation, usually through its tax accountant, completes Canada Revenue Agency (CRA) form T20545 in which the corporation elects, under subsection 83(2)6, that the dividend it proposes to pay out will be treated as a capital dividend. 2. An original of this election form, along with a certified copy of the director’s resolution
authorizing the election, must be sent to CRA on or before the earlier of the date on which the dividend becomes payable or the date it was paid. 3. A schedule showing the capital dividend account calculation immediately before the capital dividend is paid must be sent to CRA. A penalty is payable for late filing of this election form. Calculation of the capital dividend must always be left to the corporation’s accountant for two reasons. First, it can be an involved and complex calculation and second, an error in paying an amount in excess of the capital dividend account balance results in the excess being considered a separate taxable dividend to the shareholder(s), if all shareholder(s) agree; or a tax penalty to the corporation. The timing of the payment of a capital dividend is at the discretion of the corporation. It does not have to wait until the end of a fiscal year, nor does it have to pay amounts out as soon as they’re credited to the capital dividend account. However, where the capital dividend account is used in conjunction with a buy-sell agreement, great care should be taken with respect to the timing of the payment. While there’s no requirement a corporation file any other forms with CRA when paying a capital dividend, it’s good practice for the corporation to tell shareholders receiving such dividends that they are capital dividends, and therefore tax-free, if they are Canadian residents.
Conclusion The capital dividend account of a private corporation is important in ensuring tax-free amounts received by the corporation are tracked. Understanding how the capital dividend account is calculated is important. It plays a critical role for the distribution of tax-free
amounts to Canadian resident shareholder(s), including the death benefit received by the private corporation as beneficiary of a life insurance policy. 1
Gains on eligible capital property dispositions are only credited to the capital dividend account at the end of a taxation year. There is a risk of over-electing if this gain is added to and included in a tax free capital dividend that is paid before a corporation’s year-end. 2
Refers to Income Tax Act Canada, for Quebec provincial tax purposes refer section 142.1 of Quebec Taxation Act. 3
Refers to Income Tax Act Canada, for Quebec provincial tax purposes refer section 142.2 of Quebec Taxation Act. 4
Tax withholding is required if the shareholder is non-resident of Canada.
5
For Quebec provincial tax purposes also file form CO-502 with Revenu Quebec. 6
Refers to Income Tax Act Canada, for Quebec provincial tax purposes refer section 502 of Quebec Taxation Act.
